Variable dividends are a growing trend in resources and energy. How to play stocks.
For companies that inject cash, dividends are a popular way to share some of it with their shareholders. But that cash-generating power can fluctuate, so many companies in the energy and resource sectors have turned to variable dividend payments.
Here’s how it works: companies pay a relatively low base dividend that they believe they can sustain through an economic cycle, plus a variable dividend based on their earnings that often involves a formula. This differs from exceptional dividends, which are one-time events sometimes associated with the sale of a business.
Variable dividends play well with investors. They put a valuation premium on
(symbol: DVN) and
Pioneer of natural resources
(PXD), both early adopters of the variable strategy, which now post yields of around 7% between their base dividend and their variable dividend.
(COP) is another practitioner, although its combined performance is lower, at 3%.
(FANG), a major exploration and production company, plans to deploy the structure in 2022.
Variable energy dividends are expected to rise in 2022 on the back of a rise in oil prices, which hit $82 a barrel last week and could head towards $100.
And if oil bulls like Goldman Sachs commodities analyst Jeff Currie are right about an energy supercycle this decade, it could be a good decade for dividends.
Apart from energy,
(NEM), the largest gold producer, has a similar dividend approach and now yields almost 4% between its base and variable payments.
(FCX), the world’s largest copper producer, has announced a double dividend, although its yield is now modest at 1.3%.
(AGCO), the farm equipment maker, pays a base dividend of just 0.6%, but supplements it with an annual earnings-linked special dividend that has boosted its total dividend yield to 4%.
The resources sector is well positioned to pay more dividends as balance sheets are in their best shape in decades and earnings are plentiful.
“The mining industry is very much about returns to capital,” says Jefferies analyst Chris LaFemina. “With balance sheets generally repaired, there will be substantial capital returns. The only debate is the structure.
One Main Holdings
(OMF) is a rare financial firm that has pursued a version of the base/float strategy. It provides consumer installment loans at interest rates of over 20% to sub-prime customers, generating high returns. It has paid large variable semi-annual dividends over the past two years. The base dividend is $2.80 per share per year, and OneMain has paid $6.75 per share in variable dividends over the past 12 months, or a total of $9.55, for a rolling return of 17 % to its recent price of $55.
“Investors like that the company is optimizing its capital structure while earning a good dividend yield,” says John Hecht, an analyst at Jefferies who has a buy rating and a $70 price target on the stock.
Variable dividends aren’t for everyone, but they can be a good way for companies to maintain financial discipline and return cash when many investors are hungry for income.
A fan of the strategy is David King, fund manager of Columbia Flexible Capital Income. “I’m really high on companies with formula special dividends,” he said. “They are not well understood by the market.” Funds he manages directly OneMain, Pioneer and the insurer
(PGR), which has paid out excess capital as a special dividend in recent years.
|Company / Symbol||Recent Price||Change over 52 weeks||2022E EPS||2022E P/E||Basic Division*||Variable Div*||Total division return|
|One Main Holdings / OMF||$54.49||5.8%||$8.81||6.2||$2.80||$6.75||17.5%|
|Pioneer Natural Resources / PXD||204.91||51.7||20.10||10.2||2.24||12.08||7.0|
|Devon Energy / DVN||49.90||153.2||5.39||9.3||0.44||2.92||6.7|
|Newmont / NEM||61.52||-1.6||3.10||19.9||1.00||1.20||3.6|
|Conoco Phillips / COP||84.40||78.0||7.93||10.6||1.84||0.80||3.1|
|Freeport-McMoRan / FCX||45.15||45.7||3.54||12.7||0.30||0.30||1.3|
Sources: Bloomberg; business reports
The variable dividend approach differs from that adopted by
(CVX), which pay relatively high base dividends and seek to maintain them throughout the cycle. Exxon, which returns 5%, and Chevron, which returns 4.2%, had to take on debt to pay their dividends during the pandemic when energy prices crashed. They are now in a position to increase them, given the strength of oil and gas.
Devon was the first major energy company to switch to the variable dividend format a year ago. The company pays a modest base dividend of 44 cents a year, yielding less than 1% with a stock price of $49. It also paid a variable dividend of 73 cents in the fourth quarter on a formula of up to 50% of its excess free cash flow. Devon’s total dividend in 2022 could reach $4 per share, up from $3.36 annualized in the fourth quarter.
“We are meeting the expectations of our investors,” said Rick Muncrief, CEO of Devon. “They say, ‘We don’t want growth in production, and we want capital to come back to us primarily in the form of dividends rather than share buybacks.’ “Investors like the clarity of the formula,” he adds.
Resource companies are prime candidates for variable dividends due to their earnings volatility.
Steelmakers, in particular
(NUE), the industry leader, should see them as a complement to share buybacks. Nucor, whose shares trade around $110, pays a dividend of $2 a year. With its sizable earnings, Nucor favors share buybacks, repurchasing more than $3 billion in stock in 2021 while paying $600 million in dividends.
“We believe our shares are undervalued and that we are creating more shareholder value by buying back shares” than by paying a higher dividend, said Jim Frias, chief financial officer of Nucor.
(GOLD), the No. 2 gold miner, is facing pressure from investors to unveil a variable dividend to match that of Newmont. Barrick is expected to reveal its decision next month when it reports quarterly results. Newmont, whose shares trade around $60, pays a base dividend of $1 per share and a variable dividend linked to the price of gold, which is now $1.20 per year.
Jefferies’ LaFemina thinks that
(RIO), two of the world’s largest iron ore producers, are expected to adopt a basic/variable dividend structure rather than their current variable payouts, which generated big returns last year.
“A base dividend of 4% is quite doable for them,” he says, adding that it would support their stock price when iron ore prices are low. Both have little to no net debt on their balance sheets.
Apart from energy and resources, who else could be a candidate?
), the largest bank in the country. JPMorgan CEO Jamie Dimon has questioned the wisdom of share buybacks at high stock prices, saying three years ago that it would be “crazy” to buy back shares at three times tangible book value.
With its stock rallying last year to a recent $160, the bank is trading at around 2.3 times its tangible book value. Its base dividend is now $4 per share per year, a yield of 2.5% and one-third of projected 2022 earnings.
Columbia’s King, longtime holder of JPMorgan, says, “A disciplined or formulated special dividend would be an interesting idea to consider. The accounting and regulatory perspective of share buybacks at a high multiple to the tangible book is not good.
JPMorgan declined to comment.
Corporate executives in general may be reluctant to reduce share buybacks because of what it might signal about their stock price. Nevertheless, variable dividends are likely to spread and provide investors with more income opportunities.
Write to Andrew Bary at [email protected]